Advice to financial advisors thinking of going independent: Don't make the leap until you've read your current contract's fine print.
The reason: Amid all that fine print may be restrictions and conditions tied to a retention or recruitment bonus that advisors must contractually satisfy. If not, they may be financially liable and incur steep penalties if they were to make another move before those contract conditions have been satisfied.
"These advisors need to know their legal and financial obligations to their soon-to-be-former firms should they decide to leave," says Patrick J. Burns Jr., founder and managing attorney of his Beverly Hills-based law firm."Many advisors who signed the deals may not have fully understood the legal, tax and financial implications of these agreements should they leave their firm."
Burns' firm, along with wealth management consulting firm Nexus Strategy LLC, have issued an industry white paper entitled Understanding the Burden: Conditions for Going Independent With A Retention or Recruitment Bonus.
The report highlights the recent financial service industry trend that has led several thousands of advisors to sign retention and recruitment packages when joining an independent firm.
Advisors who don't carefully peruse the fine-print details in their current contracts before signing on with another firm could be financially liable for any financial restrictions or penalties that kick in when an advisor seeks to opt out early.
Burns says in some cases, advisors who are jumping ship or signing an agreement for a retention bonus to stay are not afforded the time to go through each contract detail with a fine tooth comb.
To prevent incurring such penalties, Burns says advisors should retain legal counsel to review every contract nook and cranny before signing their name to it.
"It is important to note that advisors cannot walk away from a firm and expect that firm to forget about it, write it off, or settle the claims for mere pennies on the dollar," Burns says. "Advisors considering leaving with a balance due should speak with qualified legal counsel prior to their transition so they have a good idea of what their options look like in repaying a recruitment package."
In response to the large-scale advisor migration movement over the last couple of years, the study says, traditional Wall Street brokerage firms started fighting back, offering top advisors their own lucrative retention and recruitment packages in the form of forgivable loans secured by promissory notes.
At the same time, those firms have also been engaged in an aggressive recruiting war amongst themselves, offering staggering multi-million dollar, front-end loaded recruitment packages to top advisor teams.
Much like those who signed and received the retention packages, advisors who signed these deals didn't fully understand the legal, tax and financial implications should they ever want to leave.
Burns says advisors who leave before they've satisfied all terms of their note will be held to pay back any outstanding balance.
"This can be quite an expensive proposition, particularly when considered from an after-tax perspective," Burns said.
"Signing advisors are liable because they executed a legally binding agreement and accepted compensation as consideration, Burns added. "Wall Street firms will pursue these cases, often using Financial Industry Regulatory Authority arbitration to enforce the terms of the deal."
While there's been a few cases where a departing advisor was able to settle the deal at a discount or prevailed in arbitration, advisors will increase their odds with a sound legal strategy and legal counsel, Burns maintains.
The financial advisory business was transformed by the 2008-2009 financial collapse as Wall Street firms were nearly brought to their knees by a series of wide-ranging events, product failures and mismanagement.
That damage hurt Wall Street firms' wealth management divisions, causing financial instability and posed the threat that client assets could be jeopardized. Amidst the instability, financial advisors looked for other financial channels to take their clients.
The key beneficiaries: registered investment advisors and independent broker-dealers that provided advisors freedom and flexibility to operate their practices in the way they want, unencumbered by the damaged Wall Street brands, the report says. Also appealing were the independent, fee-based models of offering non-conflicted advice along with the ability to build multi-million dollar business assets that they could sell when they retired.
The retention packages were very successful, and tens of thousands of advisors across the industry accepted them. Retention packages are typically structured as loyalty bonuses and as such, are looked at very closely by firms when an advisor is leaving with a balance due on the promissory notes.
Wirehouse firms don't want to set any precedents or expectations in the industry that they will not pursue these types of unpaid balances.
The Burns report says the recent raft of arbitration cases of firms pursuing advisors is evidence of this fact and is a reason for caution for advisors considering leaving with a balance due on a retention deal.
If an advisor who signed a retention package decides to leave the firm prior to the note becoming fully forgiven, the advisor will have to pay back any outstanding balance. For example, if a bonus payment was calculated at $2 million and is treated as a forgivable loan, then that amount would be considered taxable income and the advisor would owe the IRS and their state roughly $750,000 to $1 million, depending on their tax bracket.
If an advisor wanted to leave the next day, he might owe the wirehouse the full amount, $2 million, yet they only netted perhaps half of that because of taxes. Thus, it is no surprise that many in the industry consider these retention deals to be not just "golden" handcuffs but rather, real handcuffs.
Recruitment packages are compensation paid to an advisor to switch firms. These packages are also forgivable loans subject to a promissory note. These packages differ from retention packages in that it is typically possible for advisors to structure a payment plan and perhaps receive a discount on the outstanding balance due.